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EYE ON NEW BRUNSWICK: HIGHER TAX RATES DOES NOT NECESSARILY EQUATE TO HIGHER TAX REVENUE

The Liberal Party in New Brunswick has proposed a tax increase on the province’s wealthiest individuals, arguing it is necessary to generate additional revenue in the province (and also citing the need for all taxpayers to pay their “fair share”).

Yet, raising tax rates does not necessarily equate to raising additional revenue. Arthur Laffer, for example, illustrates this effect in the “Laffer Curve“: “At a tax rate of 0%, the government would collect no tax revenue, just as it would collect no tax revenue at a tax rate of 100%, because no one would be willing to work for an after-tax wage of zero. The reason for this is that tax rates have two effects on revenues: one is arithmetic, the other economic. The arithmetic effect is static, meaning that if rates are lowered, the tax revenues per dollar of tax base will be lowered by the amount of the decrease in the rate, and vice versa for increasing tax rates. In other words, this is what happens when a hypothetical 1% tax collects $1 million, so people assume that a 2% tax would collect $2 million… and a 5% tax would collect $5 million. Likewise, under the same scenario, people would similarly assume that a 0.5% tax rate reduction would collect only $500,000. The economic effect recognizes the positive impact that lower tax rates have on work, output, and employment, which provide incentives to increase these activities. By contrast, raising tax rates penalizes people for engaging in these activities.”

Similarly, when the government raises tax rates, especially on the most affluent taxpayers, it gives them an incentive to avoid paying taxes altogether (and, by virtue of their affluence, they have the resources to do just that). Kevin Milligan, an economist at the University of British Columbia, outlined this argument when Ontario proposed a tax hike on the wealthiest individuals in that province: “There are serious, evidence-based concerns about raising revenue through higher tax rates on the rich. The concern is less that high income earners would curtail their productive work, but more that they would have a stronger incentive to find ways around paying taxes. People earning at high levels have access to the best financial advice, and I’d be surprised if they ignored that very expensive counsel and simply hand over bigger cheques to the CRA.” Milligan is the author of a paper that analyzed this phenomenon, which is available online here.

It is possible to raise revenue without discouraging private-sector investment, providing an incentive for folks to flee, or giving them fodder to shift around their income. Milligan provided three solutions in a Maclean’s article one year ago:

1) “Pay more attention to practices that allow top earners to lower their taxable income. This is slow, hard, and challenging work—but it is also a much more effective path to making our tax system fairer than trying to pour more water into a leaky bucket.”

2) “To a large degree, the story of the top one per cent (and especially the top 0.1 per cent) is about executive compensation. … I don’t have the expertise to decisively explain patterns of executive compensation, but if I wanted to get to the source of the increase in top incomes, I might start with a thorough review of Canada’s corporate governance rules to ensure shareholders are getting a good deal from their highly compensated top employees.”

3) “Finally, if we were interested in a more radical tax reform, we could look to Sweden and other European countries with a dual income tax. Under this scheme, employment compensation is taxed on a schedule with progressively higher rates, but all forms of capital income are taxed at the same flat, low rate. A dual income tax has the potential to deliver two benefits. First, taxing all capital income at the same low rate could take some of the air out of tax avoidance because there is no longer a gain from shifting income from one type of capital income to another. (Of course, the strongest possible tax fence must be built around employment compensation to prevent leakage.) Second, since employment income is harder for people to shift around, it is easier to tax it at higher rates. This allows a more progressive rate structure than might be possible when capital income is kept in the mix. In short, a progressive tax structure on earned income (which is the source of high-income concentration) for equity, and low flat rates on capital income for efficiency.”

I have some qualms with Milligan’s suggestions, however, they deserve careful consideration—especially the part about closing the gaps in our income tax system and filling in those parts that are leaking. Simply raising tax rates on the wealthiest individuals, however, is a misguided policy approach.